As a speaker at this fall’s Investment Innovation Conference in Phoenix (November 6 to 8) Jacques Lussier, author of Successful Investing Is A Process – Structuring Efficient Portfolios For Outperformance and former Chief Investment Strategist at Desjardins Global Asset Management, will lead a seminar on why benchmark-indifferent managers and products seem to outperform.
In advance of the conference, we asked Jacques a few questions about the origins of benchmarking and why managers are moving beyond them.
To find out more about Jacques’ presentation and the Investment Innovation Conference, click here.
What is benchmark-indifferent investng?
Most investment managers use cap-weighted benchmarks like the S&P 500 or Russell 1000 index, in which the weight of a company is determined by its size measured by market capitalization. There are now, however, many managers that are no longer paying any attention to these benchmarks. They claim that these cap-weighted benchmarks are just one possible weighting mechanism among many others.
The concept of weighting benchmarks by market capitalization was introduced for the first time in 1926, but it grew in notoriety when William Sharpe and other academics formalized its economic importance in the 1960s with the Capital Asset Pricing Model (CAPM). If one is willing to swallow some strong assumptions, then the value-weighted market index was considered the most efficient portfolio. That is, the one that offered the best risk-return tradeoff. As a result, more and more managers over the following decades became benchmark aware, while consultants began to differentiate them, perhaps unfortunately, according to tracking error. We now have a wide variety of index products available and from the 1970s to the 2000s, the number of managers that are benchmark aware grew while those that paid less attention to the benchmark became much less prevalent.
What changed?
As indexing established its foothold in the investment management industry, academic finance was investigating other risk factors than the market portfolio. It is now widely recognized that the cap-weighted portfolio only partially captures variations in average returns in stocks. Many studies, most notably those of Eugene Fama and Kenneth French in the early 1990s, document other risk factors on which benchmarks should be based. We live in a genuinely multi-factorial world, and we are forced to admit that we may have been using an incomplete model all along.
Alternative benchmarks underline an inconvenient truth for indexing proponents. Many of these benchmark-indifferent products consistently outperform traditional indices. Furthermore, in a study conducted at Yale University published in 2009, two academicians found that if you look at all the active managers out there, the ones that performed the best–those ranking in the top 20%–were the most benchmark-indifferent managers who paid the least attention to benchmarks. These managers possibly have more expertise, but there could be at least another reason.
What might that reason be?
There is just not only one reason but Robert Arnott first circulated in 2004 his research on something called fundamental indexing. These products do not rely on market prices to determine allocations, but instead use other metrics such as the book value, dividend, sales and cash flows of a company. The impressive outperformance of fundamental indexing caught institutional investors’ attention. But there exists others ways of creating indices that do not resort to market prices. Equally weighted indices are the ultimate price-indifferent solution; as prices move up and down, a stock’s allocation remains fixed. Goldman Sachs is using for its GIVI (Global Intrinsic Value Index) product its own valuation formula, which is also another way of not choosing market price as an input. You could throw darts at the wall to pick stocks (a fairly market indifferent approach) and still get similar results?
Which methodology is best?
What we find is that no matter what methodology you use to determine weighting, if it’s the type of methodology that leads to a fairly diversified, not too concentrated portfolio (in other words a sensible portfolio), and if the methodology isn’t market-price dependent, almost any methodology will outperform cap-weighting over a reasonable horizon.
So, benchmark-agnostic managers, the ones that are most likely to outperform, may do so for the same reason as fundamental indexing products do. In both cases, the weightings of securities in your portfolio are not related to their market prices. By simulating portfolios randomly, we found a strong relation between outperformance and the degree of indifference towards a cap-weighted benchmark. Why this leads to outperformance will be explained. And we are only at the beginning of this discussion because this is but a small portion of the structural portfolio concepts that lead to outperformance.
Whichever successful manager you consider, whatever successful product you think of, you can almost always explain their success because they exploit some of the three structural qualities that lead to long-term performance. What we’ve talked about here is part of only one structural quality, which is avoiding the inefficiencies of traditional benchmarks. Others would call it more appropriately diversifying relative mispricing. There is much more to explain.
To learn more about the Investment Innovation Conference, please visit the conferences section of the CIR website. If you are interested in attending this event, please email Alison Webb to be considered, as limited space available.